The Role of Account Subjectivity and Risk of Material Misstatement on Auditors’ Internal Audit Reliance Judgments

Practical Implications:

This paper suggests that the relationship between account subjectivity and usage of internal audit depends on the relative risk of misstatement. This complex relationship has not been shown in academic literature, nor is it highlighted in audit standards. More specifically, at lower levels of risk of misstatement, increases in subjectivity have no influence on the reliance of internal audit. At moderate risk levels the extent of internal audit reliance increases with subjectivity of the account. At high levels of misstatement internal audit reliance decreases with account subjectivity. This study provides insight into the decision criteria for internal audit reliance and highlight where internal audit usage maybe more prevalent, as well as were further audit guidance may be beneficial.

Reliance on Internal Audit has become an important element of the external audit. Use of Internal Audit can play a significant role in reducing audit costs without sacrificing audit quality. However, the extent of usage of Internal Audit has been shown to be influenced by inherent risk, control risk, and the subjectivity of audit tasks. This paper looks at the interaction between risk assessment and subjectivity to provide insight into the complexities associated with the usage of internal audit. The authors aim to dive deeper into the analysis of internal audit usage, expanding on the dichotomous “low or high risk” assessment by investigating moderate risk scenarios. By analyzing these relationships with a field-based questionnaire, the authors present documentation of how real decisions are based on a complex assessment of the role of internal auditors.

Design/Method/ Approach:

The authors conducted a field-based questionnaire using 68 auditors from a Big 4 firm. These auditors were located in the U.S., but came from different geographic areas. They have an average experience of 46 months and represented 15 different industry specializations. The auditors were asked to choose one public company client and respond to questions regarding demographic information, client characteristics, external audit team characteristics, client misstatement risk, account subjectivity, client internal audit structure, and external audit assessment of internal audit usage.

Findings:

The authors find that auditors’ reliance decisions involve an interaction between material misstatement risk and account area subjectivity.

The authors find that incremental increases in account subjectivity have no effect on extent of internal audit reliance when misstatement risk is assessed at lower levels. At moderate levels of misstatement risk, however, account subjectivity is positively associated with use of internal auditors. This suggests that moderate misstatement risk creates opportunities for auditors to benefit from increasing internal audit utilization without offsetting impairments to audit effectiveness. At higher levels of misstatement risk, incremental increases in account subjectivity have a negative association with external audit usage.